Thursday, September 24, 2015

The Bank of England's chief economist Andrew Haldane recently called for central banks to think more imaginatively about how to deal with the technological constraint imposed by the zero lower bound on interest rates. Haldane says that the lower bound isn't a passing problem. Rather, there is a growing probability that when policy makers need three percentage points of headroom to cushion the effects of a typical recession, that headroom just won't be there.

Haldane pans higher inflation targets and further quantitative easing as ways to slacken the bound, preferring to focus on negative interest rates on paper currency, a topic which gets discussed often on this blog. He mentions the classic Silvio Gesell stamp tax (which I discussed here), an all out ban on cash as advocated by Ken Rogoff, and Miles Kimball's crawling peg (see here).

According to Haldane, the problem with Gesell's tax, Rogoff's ban (pdf), and Kimball's peg is that each of these faces a significant 'behavioural constraint.' The use of paper money is a social convention, both as a unit of account and medium of exchange, and conventions can only be shifted at large cost. Tony Yates joins in, pointing out the difficulties of the Gesell option. Instead, Haldane floats the possibility of replacing paper money with a government-backed cryptocurrency, or what we on the blogosphere have been calling Fedcoin (in this case BOEcoin). Unlike cash, it would be easy to impose a negative interest rate on users of Fedcoin or BOEcoin, thus relaxing the lower bound constraint. Conventions stay intact; people still get to use government-backed currency as a medium of exchange and unit of account.*

While I like the way Haldane delineates the problem and his general approach to solving it, I'm not a fan of his chosen solution. As Robert Sams once pointed out, Fedcoin/BoEcoin could be so good that it ends up outcompeting private bank deposits, thus bringing our traditional banking model to an abrupt end. Frequent commenter JKH calls it Chicago Plan #37, a reference to a depression-era reform (since resuscitated) that would have outlawed fractional reserve banking. If Haldane is uncomfortable with the Gesell/Rogoff/Kimball options for slackening the lower bound because they interfere with convention, he should be plenty worried about BOEcoin.

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I do agree, however, with Haldane's point that the apparatus adopted to loosen the constraint should interfere with convention as little as possible. We want the cheapest policies; those that only slightly impede the daily lives of the typical Brit on the street while securing the Bank of England a sufficient amount of slack.

With that in mind, here's what I think is the cheapest way for the Bank of England to slacken the lower bound: just freeze the quantity of £50 bills in circulation. Yep, it's that easy. There are currently 236 million £50 notes in circulation. Don't print any more of them, Victoria Cleland.**

I call this a policy of embargoing the largest value note. How does it work?***

Say that in the next crisis, the Bank of England decides to chop rates from 0.5% to -2.0%. Faced with deeply negative interest rates, the UK runs smack dab into the lower bound as Brits collectively try to flee into banknotes. After all, banknotes offer a safe 0% return, the £50 note being the chosen escape route since those are the cheapest to store and convey.

Flooded with withdrawal requests, banks will quickly run out of £50s. At that point the banks would normally turn to the Bank of England to replenish their stash in order to fill customers' demands. But with the Bank of England having frozen the number of £50s at 236 million and not printing any new ones, bankers will only be able to offer their customers low denomination notes. But this will immediately slow the run for cash since £20s, £10s, and £5s are much more expensive to store, ship and transfer than £50s. Whereas people will surely prefer a sleek high denomination note to a deposit that pays -2%, they will be relatively indifferent when the choice is between a bulky low denomination cash and a deposit that pays -2%. Thus the lower bound has been successfully softened by an embargo on the largest value note.

Once negative interest rates have served their purpose and the crisis has abated, they can be boosted back above 0% and the central bank can unfreeze the quantity of £50s. Everything returns to normal.

A few conventions will change when the largest value note is embargoed.

1. People will no longer be able to convert £50 worth of deposits into a £50 note. Instead they'll have to be satisfied with getting two £20s and a £10. That doesn't seem like an expensive convention to discard. And if folks really want to get their hands on £50s, they'll still be able to buy them in the secondary market, albeit at a small premium.

2. In normal times, £50 notes always trade at par. Because their quantity will be fixed under this scheme, £50s will rise to a varying premium above face value whenever interest rates fall significantly below zero. For instance, at a -2.0% interest rate a £50 note might trade in the market at £51 or £52.

The par value of £50 notes is a cheap convention to overturn. The majority of the British population probably don't deal in £50s anyways. Those who do use £50 notes in their daily life will have to get used to monitoring their market price so that they can transact at correct prices. But the inconveniences faced by this tiny minority is a small cost for society to pay in order to slacken the lower bound.

3. Importantly, there will be no need to proclaim a unit of account switch upon the enacting of an embargo on £50s; the switch will be seamless.

Because the £50 was never an important part of day-to-day commercial and retail existence, come negative interest rates no retailers will set their prices in terms of a £50 standard. If they do choose to set sticker prices in terms of the £50 note, they will find that if they want to preserve their margins they will have to levy a small surcharge each time someone pays with £20s, £10s, and £5s and bank deposits. Given the prevalence of these payment options, that means surcharging on almost every single transaction. That's terribly inconvenient. Far better for a retailer to set sticker prices in terms of the dominant payments media—£20s, £10s, and £5s and bank deposits—and provide a small discount to the rare customer that wants to pay with £50s.

It's entirely possible that the majority of retailers will not bother offering any discount whatsoever on £50s. This would effectively undervalue the £50 note. Gresham's Law tells us that given this undervaluation, the £50 will disappear from circulation as it gets hoarded under people's mattresses. For the regular British citizen, never seeing £50s in circulation probably won't change much. And anyone who does want a £50 can simply advertise on Craig's list for one, offering a high enough premium to draw it out of someone's hoard.

In closing, a few caveats. The figures I am using in this post are ballpark. It could be that a policy of freezing the supply of £50 notes allows the Bank of England to get to -2%. But maybe it only allows for a level of -1.75%, or maybe it slackens the bound so much as to allow a -2.5% rate.

Haldane mentions that the Bank of England could need 3% of headroom to combat subsequent recessions. But as Tony Yates has pointed out, in 2008 bank officials calculated that a -8% rate was needed. The Bank could get part way there by not only embargoing the £50 but also the next highest value note; the £20. But that probably wouldn't be enough. As ever smaller notes have their quantities frozen, this starts to intrude on the lives of the people on the street, making the policy more costly. If it needs to slacken the lower bound in order to allow for rates of -8%, I think the Bank of England should be planning for a heftier policy like Miles Kimball's crawling peg. After all, when the sort of crisis that requires such deeply negative rates hits, the last thing we should be worried about is disturbing a few conventions. Until another 2008-style crisis hits, embargoing large value notes might be the least intrusive, lowest cost option.

*Of these policies, I think Miles Kimball's plan is by far the best one.**Specifically, the Bank would only print new bills to replace ripped/worn out bills. Otherwise the outstanding issue will wear out and become easier to counterfeit. As for Scotland, which issues 100 pound notes, their quantity would have to be fixed as well.*** I first mentioned the idea of embargoing large notes in relation to the Swiss 1000 CHF note, and later elaborated on it in the Lazy Central Banker's Guide to Escaping Liquidity Traps.

Friday, September 11, 2015

A common argument against the Fed raising interest rates next week is the asymmetry in risks that it faces. If it keeps rates low too long and sets off inflation, no problem: it can quickly hike rates a few times to bring prices back in line. However, if it boosts rates too early and an unintended slowdown sets in, the Fed won't have room to cut a few times in order to fix its mistake. That's because the Fed is at the zero lower bound, the edge of the world in monetary policy terms. To avoid this conundrum, the Fed should hold off as long as possible before raising, at least until it "sees the whites of inflation's eyes."

As Paul Krugman points out, the asymmetry argument is only a recent one. Historically U.S. interest rates have hovered far above zero. If the Fed made a mistake, it didn't have to worry about falling off the edge of the world in order to fix the situation, it could simply ratchet rates down a few times. Rather than waiting till the last minute to see the whites of inflation's eyes before hiking, the FOMC only had to hear the creak of inflation at the door.

I don't buy the current asymmetry argument. I might have bought it back in 2013, but the data has changed.

Over the last year, Sweden, Switzerland, Denmark, and the ECB have all demonstrated to the world that central banks can safely lower rates into negative territory without setting off the sorts of ill effects that economists have always feared, the main one being a race into 0% yielding cash. The theory here is that if a central bank reduces rates to, say, -0.1%, then paper cash—which pays a superior 0% return—starts to look pretty attractive. An arbitrage process begins whereby central bank deposits are converted into cash until all deposits have disappeared. Thus rates can't be reduced below 0%.

Evidence over the last 12 months shows otherwise. Denmark's Nationalbank has kept its deposit rate at -0.75% since early February. Danes, however, are not scrambling for banknotes, as the chart below shows. After seven months of negative rates, cash and coin outstanding are growing at a rate that lies pretty much at its two decade average.

The Swiss National Bank has maintained a -0.75% overnight rate since January, yet there's been no spike in Swiss paper franc demand, as the next chart shows. In fact, cash outstanding seems to be growing at one of its slowest rates in years.

We'd expect the demand for Swiss cash to be especially sensitive when interest rates fall below zero because the SNB issues the world's largest value banknote; the hefty 1000 sFr. The more valuable the banknote the lower the cost of storing wealth in cash form. These carrying costs are particularly important in determining the profitability of flight into cash at negative interest rates. A central bank can push rates a sliver below 0% without setting off a flight out of deposits into banknotes as long as there are inconveniences in storing cash. The greater these inconveniences, the larger that sliver.

The fact that the SNB has been able to keep rates at -0.75% for seven months now without setting off a stampede into 1000 notes indicates that the burdens of holding Swiss currency are higher than everyone had previously thought. It would seem that investors would rather lose 0.75% each year than bear the costs of storing 1000s. At some negative interest rate, maybe -1.5%, the flight into Swiss notes will start. But it hasn't yet. As for the U.S., its highest value banknote is the lowly $100, so it's fair to assume that the costs of storing U.S. paper money are significantly higher than Swiss money. Which means that if the Swiss can safely cut to -0.75% without setting off cash arbitrage, the Fed should be able to descend to at least -1.0% before panic ensues.

The second greatest fear surrounding sub zero U.S. rates has always concerned money market mutual funds. The worry here is that should the Fed reduce rates too deep, a financial intermediary known as a money market mutual fund (MMMF) will 'break the buck,' causing panic and terror among ordinary investors.

MMMFs are like regular mutual funds except their share price stays fixed at US$1.00. Investors can cash out at that price whenever they want, enjoying low but steady dividend payments until then. MMMFs maintain par conversion by investing in safe, highly liquid short term debt. However, if the Fed were to drive short term rates into negative territory, MMMFs would be forced to invest in assets that promise a negative return. $1000 invested in t-bills, for instance, would be worth only $999 upon maturity. That means that an MMMF simply wouldn't have a sufficient quantity of assets to allow everyone to redeem their shares at US$1.00. The fund will "break the buck," or mark its share value down to something like 99 cents to allow for full redemption. Since MMMFs are supposed to be cash-like—in fact, many of them offer cheque-writing capability—such a development would be disastrous, or so goes the story.

I don't consider breaking the buck to be a terrible outcome, but even if it is, European money market mutual funds—faced with negative interest rates—have already found an ingenious way to avoid it; a Reverse Distribution Mechanism. Rather than reducing redemption below par, MMMFs simply dock the number of shares that each shareholder has in his or her account. For example, as rates slide below zero, instead of 100 units being worth only $0.99 each, a shareholder forfeits one unit and ends up with 99 units worth $1.00 each. The deeper rates fall, the less units each investor owns. The genius of this patch is that the purchasing power of each share stays constant, but the negative interest rate is efficiently passed on to the owner of the MMMF.

So fears of a dash into cash at 0% and a collapse of MMMFs are just bogeymen. If the Fed hikes to 0.5% this month—and this proves to be a mistake—it still has plenty of room to make things right. Given how well Europe has coped over the last twelve months, the Fed can easily cut rates another 1.5% to -1.0%; that's six quarter-point reductions or thirty ten-point cuts. Only when rates falls beyond Swiss or Danish levels, say to -1.0%, will the Fed find itself in truly asymmetrical territory. (If necessary, here are some simple ways to allow for even more negative rates).

To be clear, that doesn't mean I think the Fed should hike rates next week. The fact that the FOMC continues to undershoot its 2% core inflation target would seem to indicate that holding off might be the right thing to do. Rather, I don't think that Fed policy makers need to wait to see the white's of inflation's eyes before they hike, they need only wait to hear the creak of inflation at the door.

Saturday, September 5, 2015

If you're like me and you like to: 1) explore anomalies in markets; and 2) mix equity analysis with monetary analysis, then you'll like this post. A sneak peak: by the end, we'll be able to use equity markets to figure out the unofficial exchange rate between a Greek euro and non-Greek euro.

For the last few weeks shares of Greek banks have diverged dramatically from their overlying depository receipts (see chart below). A bit of background first. A depository receipt is much like an exchange-traded fund, except where an ETF holds a bundle of different stocks, a depository receipt represents just one stock. That stock is usually listed on an out-of-the-way market (like Greece), whereas the depository receipt trades on a major exchange like New York. Investors interested in owning a foreign stock can avoid currency conversion costs and foreign settlement problems and instead purchase the New York-listed depository receipt hassle-free.

In general, the parent security and its offspring should trade in line with each other. Recently, however, the US-listed depository receipts of the National Bank of Greece and Alpha Bank have risen to a massive premium relative to their Greek-listed parents. For instance, in mid-August investors could have bought National Bank's New-York listed depository receipt for €0.73. However, the Greek-listed stock was trading for just €0.60. For some reason, investors are paying 30% more for a security that provides the exact same stream of earnings. We've got a gross violation of the law of one price.*

This is especially interesting given that a redemption/creation mechanism for depository receipts links the price of parent and offspring via arbitrage. In the same way that an investor deposits cash at a bank and gets a bank deposit, an investor can buy a National Bank of Greece share listed in Athens and 'deposit' that share at a custodian, receiving in return a newly-created New York-listed depository receipt. If either security can be bought for less than the other, an arbitrage opportunity arises. For instance, in mid-August one might (in theory) have bought Greek-listed National Bank of Greece shares for €0.60, converted them into New York-listed depository receipts, sold the depository receipts for €0.73, wired the proceeds from New York to Greece, and repurchased Greek-listed National Bank of Greece shares for €0.60. Rinse and repeat. (This works the other way, too. In the same way that a bank deposit can be converted into cash, investors can purchase a depository receipt and redeem it for underlying equity.)

The effect is that as investors clamour to harvest arbitrage gains, any premium or discount between a New York-listed depository receipts and its Greek parent equity should quickly fall towards zero. Why hasn't this been the case in Greece of late?

There are several explanations for persistent premia/discounts between depository receipts and their underlying shares. The first is liquidity differences. If the depository receipt is more liquid than the underlying equity, then investors will be willing to pay a bit more for the depository receipt. In the case of National Bank of Greece, the depository receipt tends to attract higher trading volumes than the underlying Athens-listed shares, which probably explains why the receipts have tended to trade at a premium.

Premiums or discounts can also occur when the redemption/creation mechanism is inhibited. Depository receipts for Taipei-listed Taiwan Semi Conductor rose to an incredible 60% premium to the shares in the late 1990s and early 2000s. The reason for this premium can be traced to the fact that Taiwan restricts foreign ownership of local companies. This effectively prevented the closing of the premium via purchases of local shares for conversion into depository receipts. These premia evaporated when Taiwan removed foreign ownership restrictions in 2003. (Here is a good summary).

In a 2006 paper, Saxena found that the New York-traded depository receipts of a handful of Indian stocks, including Infosys, Wipro, State Bank of India, MTNL, ICICI Bank, HDFC Bank and Satyam Computers, habitually traded at substantial premium to the underlying Indian-listed equity. Infosys's premium (which reached 60% in 2002) had existed since its U.S. listing in 1999. However, German, South Korean, and Hong Kong-listed companies with New York-listed depository receipts showed negligible premia.

Why was this? Saxena found that Indian depository receipts suffered from limited two-way fungibility. Depository receipts could be freely converted into Indian-listed shares, but Indian-listed shares could only be converted into depository receipts to the extent that there was available 'head room'. The amount of headroom in turn depended on the extent of past conversion of depository receipts into shares. Since headroom in the above shares had been all used up, when American investors flocked to buy depository receipts, thus driving them to a premium relative to the Indian-listed equity, there was no way for arbitrageurs to close the difference.

In the case of Greece, the imposition of capital controls on June 29 seems to have inhibited the redemption/creation mechanism. The Athens stock exchange was closed the same day (the New York-listed receipts continued to trade), but when it reopened on August 3, capital controls remained in place. Since reopening, a wedge has appeared between the prices of National Bank of Greece's depository receipts and its underlying shares, implying that there has been much more demand for the former than the latter. Typically, arbitrageurs would close this gap, buying the underlying Athens-listed shares and turning them into new deposit receipts. Presumably the Greek authorities have asked that banking intermediaries cease allowing the conversion of Greek shares into receipts, so arbitrage has not been possible.

That ended on August 27, 2015. According to a press release for BNY Mellon, clarification requested from Greek authorities regarding conversions of depository receipts had finally been received and, as a result, deposit receipt books would be re-opened for issuance and cancellation. With the ability to arbitrage receipts and the underlying shares once again available, the National Bank of Greece depository receipt premium collapsed from around 30% to 10% when markets opened on August 28. It has been shrinking ever since and now lies within its historical range.

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That explains the anomaly and its disappearance. But that's not the end of the story. Going forward, watching the relative price of National Bank of Greece's depository receipts and its share price may provide valuable insights.

In permitting depository receipt redemption and creation, the Greek government has effectively removed capital controls. Currently, Greeks cannot withdraw more than €420 in cash per week from their bank accounts and are not permitted to transfer more than €500 per month to a foreign account. Businesses must go through tedious application processes to get access to their funds. However, with the depository receipt window open, businesses and individuals can simply spend all their bank deposits on Athens-listed National Bank of Greece, convert the shares into depository receipts, sell them in New York for dollars, and convert the funds back to euros. Voila, capital controls evaded.

This loop hole doesn't seem very fair to me. After all, only the financial elite will be aware of the depository receipt escape, with widows, orphans, and the rest oblivious that capital controls have been effectively lifted. Loosening up the depository receipt window only make sense if it is twinned with similar effort to help the broad public, say a higher ceiling on cash withdrawals.

Depending how tightly Greece's capital controls bind, Athens-listed National Bank of Greece shares might actually lose their traditional discount and rise to a premium relative to New York-listed depository receipts (in euro terms). If depository receipts are the best route to evade capital controls, then those desperate to get their money out of Greece will be willing to pay a 'fee' for that privilege. By purchasing National Bank of Greece shares in Athens for, say 0.65 euro, and converting them into depository receipts that trade for just 0.60 euros, investors effectively lose 0.05 euros. The size of that fee, the premium, will equal the cost of the next best alternative for evading capital controls. If controls are leaky, the premium will be small. If they aren't, it could be quite wide.

A number of studies have found that during the Argentinean corralito, Buenos Aires-listed shares rose to a huge premium relative to their New York-listed depository receipts. Brechner, for instance, finds that the premium reached over 40% in January 2002. This gap represented the amount that Argentinians were willing to pay to use depository receipts as a vehicle for moving their wealth from frozen Argentinean bank deposits into liquid U.S bank deposits. When share conversions were restricted in March 2002, that premium disappeared.

Greece seems on its way to being mended. Capital controls should be loosened soon, and people no longer seem anxious about an imminent drachma conversion. So if a premium on local National Bank of Greece shares were to develop, I doubt it would be large like the sort of premia that prevailed in Argentina. However, if things were to get worse, we might see a large gap develop.

In closing, now that depository receipt conversion has been reopened but capital controls remain in place, the exchange rate between Athens-listed National Bank of Greece shares and New York-listed depository receipts serves as the "black market" rate between Greek euros and non-Greek euros. After Hugo Chavez imposed capital controls in 2003, Venezuelans used the rate between Caracas-traded CA Nacional Telefonos de Venezuela (CAN TV) shares relative to New York-listed depository receipts as a shadow rate for the Venezuelan bolivar, until CANTV was nationalized in 2007. Likewise burdened by capital controls, Zimbabweans used the exchange rate between Old Mutual shares listed on the Zimbabwe Stock Exchange and those listed in London as the implicit Zimbabwe dollar exchange rate. It even had a name: the OMIR, or Old Mutual Implied Rate.

* More accurately, the depository receipts were trading for US$0.83. To calculate their euro price, I use the 9:30-10:30 price of New York-listed National Bank of Greece depository receipts and converted them into euros at the prevailing dollar-to-euro exchange rate.